TEAMThink 12-21-2012

TEAMThink 12-21-2012

Executive Summary

- I explain the circumstances that have driven the recent, and significant, decline in client portfolios.- All
of the major positions we've maintained have been punished severely
over the past month, as investors engaged in an explosive rush into risk
assets and gold/miners have declined. - Market conditions have
progressed to a level of instability that is very rare, as certain
extremes have gone to levels we did not anticipate. However, moving to
further extremes and enduring for longer than we thought possible,
only increases the degree to which we expect markets to adjust to
normalize the extremes. - We recognize that the scope
of portfolio declines our investors have suffered over the past month is
beyond their expectations and comfort levels. Like risk markets
suffered in the fall of 2008, our strategy has experienced a "perfect
storm" of sorts. Panicking from most risk assets during the fall of 2008
proved to be a poor long term decision. We believe sticking with our
discipline and strategy during this difficult period will ultimately
prove to be profitable.

Our Own Personal Fall 2008

I
had initially intended to write a post regarding the Fiscal Cliff, but
given the events in markets and our portfolios over the past two weeks, I
believe there are more pressing matters to discuss. I've included a
relatively brief section on the Fiscal Cliff at the end.

The
past 4 weeks have resulted in our strategy suffering its own version of
the fall of 2008. While things can always be worse, in almost all
respects we've experienced a "perfect storm" for how we've been
positioned. Given the size of the decline in the portfolios we manage,
both separate accounts and our fund, it is self evident that we were ill
prepared for the scope of the recent market move. My goal in today's
post is to explain what has driven this "perfect storm," its impact on
how we've been positioned, and what we are doing going forward. The
extent of the declines our investors have experienced have naturally
created a lot of anxiety and concern, so I hope this provides some
context.

The reason I label the recent market environment as a
"perfect storm" for us is that practically every major intermediate and
long term tactical and strategic positioning that we've maintained moved
violently against us over the past month. I read one blogger this week
who used the phrase "Belief Bubble" to describe the recent market
environment, and I think that is an apt characterization. As I described
in the prior blog post on 12/7/2012, one of the factors we try to
assess and consider within our analytical framework is how investors
will collectively render judgment on the market Rorschach test. Our
judgement in this regard has been woeful over the past month, as
investors have progressed into a flurry of risk taking that we thought
to be extremely unlikely, and we have clearly been wrong.

The four charts I am sharing today all come courtesy of www.sentimentrader.com.
The first is an index which is a composite of various measures of risk
taking across markets. It incorporates things like equity and foreign
exchange volatility, credit spreads, relative performance between more
aggressive stock market sectors like Industrials versus more defensive
sectors like consumer staples. As you can see from the chart immediately
above, the index has reached its highest level since early 2010. You'll
also see that the November low did not develop off of any kind of major
spike in risk aversion, as compared to the big trading lows from August
2011 and June this year. We have been positioned with the belief that
"bear market rally" would develop once markets showed a greater degree
of fear, but that did not occur. After just a modest spike in risk
aversion, investors came flooding back into taking risk. The result was
risk markets exploding higher and our hedges/shorts getting hit very
hard.

This
next chart helps explain the other side of why our portfolios have been
hit so hard in recent weeks. It shows a survey of gold newsletter
writers and their aggregate recommended allocation to gold. The drop
over the past eight weeks has been significant, as sentiment towards
gold and related mining stocks has turned quite sour. This chart is only
through last week, so I'd expect the updated chart to drop below the
zero line given the hard hit gold and the miners suffered this week.
Sentiment tends to follow prices, so the drop in bullishness in
gold/miners reflects the sharp drop in prices they've experienced. The
result has been our largest investment area getting hit hard at the same
time our hedges/shorts have been hit hard.

This
next chart is one I shared a while back and it shows the amount of VIX
futures contracts commercial hedgers are long versus speculators being
short. The VIX is an indicator that provides insight into the relative
cost of buying put options - i.e. insurance. This chart shows the VIX
for US large cap stocks, and you can see that the degree to which
speculators have sold VIX futures has gone from unusually large to what I
would deem crazy. This "selling of volatility" creates buying pressure
on markets as long as it endures. However, it also serves to
exponentially increase market risks, as when/if a market decline begins
to unfold with momentum, the degree to which speculators have sold
volatility may cause a cascade of forced selling. With the already
unprecedented level of "short volatility" present as markets declined
into the November low, we were too complacent in adjusting once markets
began to rally. This proved to be a costly decision in the short term.

The
next chart is similar to the VIX chart above, only it compares the
relative positioning of commercial hedgers versus speculators in the
Australian dollar. The first chart at the top of this post includes
volatility levels in foreign exchange, and the volatility selling in
"risk currencies" like the Australian dollar has been epic. In a low/no
yield world, one favorite trade by speculators is to borrow in low/no
yield currencies like the US dollar, and move the borrowed money into a
higher yielding currency like the Aussie, and then harvest the "carry."
This "carry" is the difference in the yield between the two currencies.
It appears that such carry trades have once again approached the kind of
levels which preceded the 2008 crisis, with the added dose of massive
volatility being sold for speculators try to squeeze even more income
out of the low/no yield world. When the carry trade imploded in 2008,
the US dollar rallied over 35% versus the Australian dollar over a 15
week period.

What Reason is there for Optimism?

In
each of these instances, we've identified what we believe to be
inherently unstable situations whose degree of criticality was already
at extreme levels a month ago. The conditions have now progressed to a
degree to which we believe markets are currently extremely unstable.
We've been the skunk at the garden party over the past month and payed a
significant price, as markets have moved against nearly all of our
positions. However, the underlying drivers for our positioning have only
become more overwhelming. While the decline we've suffered in client
portfolios has been far more severe than I expected, I also believe that
size of the current disconnect provides the opportunity to
recoup recent losses (and then some) in a rapid fashion.

The
result is of this is a dichotomy which is very challenging. How do we
sustain positioning which we have an extremely high conviction level,
while also trying to make "temporary" losses at a level which
are recoverable. The nature of the rally off the November low has
stretched us to our very limit in this regard. While we obviously did
not anticipate the flood into risk assets over the past month, our
analytical process is constructed to account for such a scenario. The
momentum peaks reached this week in the vast majority of risk markets
across the world, should be "terminal" if our outlook is to prove
accurate from here going forward.

Fear+Misery+Exhaustion+Capitulation= Bottoms

In
some respects, this topping process over the past three months has been
a mirror image of the 2008-2009 bottoming process. Many global stock
markets, currencies and commodities bottomed in October or November
2008, while the US stock market proceeded to make a significant new low
into its final bottom. Despite fear and loathing reaching a new low in
March 2009, the vast majority of global markets made a higher low at
that time, which preceded the launch into the recovery markets enjoyed.
This also coincided with the business cycle bottoming and the recession
ending in June 2009.

The recent top developed with US
markets peaking in September and suffering the correction down to the
November low. Off the November low, many global stock markets and
currencies proceeded to explode to levels above the spring 2012 or
September 2012 peaks. The German DAX moved to a new cycle high this
week, which has that index joining the US as the two major global stock
markets which have exceeded the peaks hit in spring 2011.

Despite
well over $10 trillion in money being printed by various central banks
around the world, the 'advance/decline" line for global markets has not
even come close to making a new cycle high this year. Risk appetite has
made a new high, which is a negative divergence - just as the new high
in fear in March 2009 was a positive divergence. The degree to which
people holding positions like ours have capitulated appears to be very
significant. Hedge funds are holding near record high exposure to global
stocks. Volatility has been sold by speculators (like hedge funds) at
level rarely if ever seen in the past. Retail and institutional
investors have inhaled record amounts of low quality junk bonds. The
chase for yield has also resulted in a massive global carry trade in
currencies. The confluence of this kind of data suggest market
conditions that have preceded most of the largest market declines in
history, whether it is 1929-1932, 1973-1974, 1987 or 2007-2009.

Portfolio Positioning

As
I stated above, while we've certainly done a poor job
anticipating and/or responding to the market conditions over the past
month, our process does/did account for such a scenario within our
cyclical outlook. However, the rubber band has been stretched to such an
extent that is very rare and we expect to see markets respond in a very
significant way over the next 4-5 weeks. If they do not, then we may be
forced to reduce/alter the exposure we have, which has been oriented to
capitalize on the various extremes I mentioned above unwinding. The
response of markets Friday is an encouraging start.

Fiscal Cliff

Outside
of a short term Rorschach test relative to investor psychology, I view
the Fiscal Cliff as a question of how negative the outcome will be for
the cyclical economic outlook. None of the proposals currently under
debate even make a dent in the long term fiscal problems facing the
US. Neither political party is willing to propose reducing entitlement
benefits or increasing taxes on the middle class, which is where the
vast majority of the budget resides. Every single proposal under
consideration imposes some degree of shorter term austerity to the
economy. The big uncertainty is to what extent taxes will be raised and
spending cut.

Regardless of one's political views, increased
taxes and/or spending cuts have a de facto negative impact on the
economy short term. I believe the best case argument someone can make is
that the US economy is at stall speed (we think it is already 4-5
months into recession), which means it is inherently vulnerable to
shocks. Any tax increases or spending cuts will create some degree of
shock and could accelerate an already unfolding recession. This is quite
common within business cycle dynamics, as the vast majority of
people assign causation to a shock for launching a recession, when in
many cases they are accelerants that simply worsen the contraction. The
financial crisis and Lehman Brothers was a good example of this in
2008, where some people still state that the collapse of Lehman caused
the recession, when in fact the recession began in December 2007.

The
broad consensus we read and hear is that any resolution of the Fiscal
Cliff will unleash businesses and consumers, who have supposedly
been holding back on economic activity due to uncertainty. While the
incessant media coverage of the Fiscal Cliff has surely had an impact,
various economic metrics have been progressing in a classic recessionary
sequencing for over a year. The business cycle is what is driving these
factors, and just as if Lehman Brothers hadn't of collapsed a recession
would have still have occurred. The counter factual is always
theoretical, so some other crisis could have still plunged the economy
into recession in 2008 had it not been Lehman, just as some other crisis
could do the same in 2013 even if the Fiscal Cliff is "resolved."

The
most market friendly Fiscal Cliff deal, in my opinion, would be a
continuation of the status quo - i.e.extend the tax cuts for all and
eliminate any spending cuts. Of course, there appear to be no chance of
that kind of deal occurring, so the question becomes how big of a fiscal
drag will an eventual deal, or no deal at all, be on the economy? Every
scenario we see as plausible will create some fiscal drag, which will
inherently contribute to slower economic growth in the near term. In
environment of recession and corporate profits contracting, any fiscal
drag at all raises risks of a deeper and more prolonged recession -
something for which equity markets are not pricing in at all - in my
opinion.

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